Introduction A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions made about the operation of the market. All markets are “competitive” to one degree or another, but the vast majority of markets are characterised as “imperfectly competitive”. We do, though get closer to perfect competition in many markets for agricultural and other primary commodities. These are the only markets where there are enough sellers of products that are near perfect substitutes for each other. Meaning Perfect competition describes a market in which no buyer or seller has market power. Such markets are usually allocatively and productively efficient. In general a perfectly competitive market is characterized by the fact that no single firm has influence on the price of the product it sells. Because the conditions for perfect competition are very strict, there are few perfectly competitive markets. A perfectly competitive market may have several distinguishing characteristics, including: Many buyers/Many Sellers – Many consumers with the willingness and ability to buy the product at a certain price, Many producers with the willingness and ability to supply the product at a certain price. Homogeneous Products – The products of the different firms are EXACTLY the same, e.g. salt. Low-Entry/Exit Barriers – It is relatively easy to enter or exit as a business in a perfectly competitive market. Perfect Information - for both consumers and producers. Firms Aim to Maximise Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit. Main Assumptions of Perfect Competition • Each firm produces only a small percentage of total market output. It therefore exercises no control over the market price. For example it cannot restrict output in the hope of forcing up the existing market price. Market supply is the sum of the outputs of each of the firms in the industry • No individual buyer has any control over the market price - there is no monopsony power. The market demand curve is the sum of each individual consumer’s demand curve – essentially buyers are in the background, exerting no influence at all on market price • Buyers and sellers must regard the market price as beyond their control • There is perfect freedom of entry and exit from the industry. Firms face no sunk costs that might impede movement in and out of the market. This important assumption ensures all firms make normal profits in the long run • Firms in the market produce homogeneous products that are perfect substitutes for each other. This leads to each firms being price takers and facing a perfectly elastic demand curve for their product • Perfect knowledge – consumers have perfect information about prices and products. • There are no externalities which lie outside the market Evaluation: The Realism of Perfect Competition as a Model Many economists have questioned the validity of studying perfect competition. However the theory does yield important predictions about what might happen to price and output in the long run if competitive conditions hold good. There are still markets that can be considered to be highly competitive and in which competition has strengthened in recent years. Good examples of competitive markets include: • Home and car insurance • Internet service providers • Road haulage Such markets are likely to exhibit the following features: • Lower prices - because of the large number of competing firms. Suppliers face highly elastic demand curves and any rise in price will lead to a large fall in demand and total revenue. The cross- price elasticity of demand for one product with respect to a change in the relative price of another will be high • Low barriers to entry – new firms will find it easy to enter markets if they feel there is abnormal (economic) profit to be made. The entry of new firms provides extra competition and ensures prices are kept low • Lower profits than those in markets dominated by a few firms • Economic efficiency – competition will ensure that firms attempt to minimise their costs and move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the needs of consumer. This is known as dynamic efficiency According to the Pure or perfect competition, or ideal, only if they possess the following characteristics Every industry must have hundreds of firms and potential entrants, each firm with tiny shares of the overall market. Potential entrants must have equal and virtually cost- free access to the industry. Each firm must be completely devoid of any power to influence the price of his product or to alter his market share. Within each industry the products and services of each firm must be virtually indistinguishable from those of other firms; with no need to differentiate one's offerings, ideally there should no promotion or advertising; if there is, it's a waste. Profits are non-existent; if then exist there is an imperfection. Prices would be too high. A firm's price should only cover a its "marginal costs"--those are the variable costs a firm incurs, the extra costs needed to produce extra goods, such as materials, fuel, inventory and labor; in pricing its product a firm does not cover fixed costs, those costs associated with plant, equipment, and patents, because these assets already exist. Since, in fact, fixed capital wears out and must be replaced, the requirement that price cover only marginal costs means that the "ideal" situation is firms showing losses. Finally every firm, consumer and investor must have cost-less and "perfect information" about the state of prices, production, employment and markets as well as of each others' intentions--this despite the fact that it costs time and effort to produce valuable information and despite the "ideal" requirement that there be no advertising. The firm’s objective is to produce the level of output that will maximize profit. Economic profit = total revenue minus total economic cost. o Total revenue = price x quantity sold. The Revenue Structure of the Competitive Business Firm The perfectly competitive firm is a price-taking firm. This means that the firm takes the price from the market. As long as the market remains in equilibrium, the firm faces only one price—the equilibrium market price. Computing the Total Revenue of a Price-taker Since the perfectly competitive firm faces a constant price, the shape of its total revenue is an upward-sloping line. Total revenue changes only with changes in the quantity sold. The Totals Approach to Profit Maximization To maximize profit, a producer finds the largest gap between total revenue and total cost. The Marginal Approach The other way to decide how much output to produce involves the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost. Marginal Revenue The benefit of producing and selling rakes is the revenue the firm collects. If the firm sells one more rake, total revenue increases by $25. Marginal benefit = marginal revenue = market price The Marginal Rule for Profit Maximization A firm maximizes profit in accordance with the marginal principle—by setting marginal revenue (or market price) equal to marginal cost. Profit Maximization Using the Marginal Approach Economic Profit Profit per unit equals revenue per unit (or price) minus cost per unit (or average total cost).